Advantages of Commercial over Residential -- Feedback Requested

Multi-Family and Apartment Investing
9yFollow

Advantages of Commercial over Residential -- Feedback Requested

Louis A.
Investor · Chicago, IL · Member since 2015 · 70 posts · 27 votes

Hello Fellow BP Gurus! As the subject suggests, I'm trying to determine whether to dip my feet into Commercial. I've gone back and forth with the debate -- At the end of the day, I have ultimately stayed on the residential side. 

As background: I have 4 multi-unit properties, each with 4 units or less.
I would consider them all to be "B" grade properties with very decent / respectable returns.
What I love most is that they all qualify for Freddie/Fanny financing -- Rates are incredibly low and I love the long-term predictability cash-flow requirements for a 30 year fixed mortgage. It also helps me achieve one of my goals .... 20% or higher Cash on Cash returns. 

I understand that Cap rates can be a bit more attractive for commercial. What scares me the most however are the limited term loans (often 5 years) that are based on a 20 year amortization schedule -- Also, the relative uncertainty of being at the mercy of what the prevailing rates are when it comes time to refinance is a bit hard to stomach for me.

So many here are proponents of Commercial, and I trust for good reason. Clearly many of you have overcome what I perceive to be sticking points .... I'm interested with how you all have done so. Perhaps there are other reasons which I've not contemplated -- Appreciate your feedback there too.

All the best and thank you all in the advance for your feedback!

0Reply
14 views

Most Popular Reply

Arlen Chou
Investor · Los Altos, CA · Member since 2014 · 942 posts · 1k+ votes
9y

@Amit M. thanks for bringing me into this discussion. I am not sure if my perspective will help, but it might be entertaining for a few...

@Louis A.

My personal time horizon is measured in decades and generations, so take the following with a grain of salt.

There are many good reasons to be on either side of this fence. I personally came up through house hacking, then SFR's, then a light industrial building, then some small multi-families, and most recently into "commercial" residential. There are many good reasons to focus on any one of these market segments. Each market niche has its strengths and weaknesses. I believe that matching your personal strengths and weaknesses to the niches is how you will find the right strategy for yourself. Although maximizing things like COC and the best interest rates are extremely important, I think a strategy that fits your lifestyle/personality is more important.

My personal philosophy is to always be a noobie, so I push my boundaries to test myself and see what I like and dislike and invest in several arenas. I will eventually focus on a single strategy once I either find one I really like or get to tired and need to settle for a market that works on paper.

I cannot really comment on what might be the best strategy, because as others have said it depends on your goals and timelines. What I can tell you is that I have found through the various market niches is that the common denominator is financing... If you can figure this piece out for yourself, you will be able delve into different market niche and jump back out if you find that a space is not to your liking. At least that is what I am doing. The physical analysis process for the different types of buildings might be slightly different, but the basic principles apply to all properties. On the financial side, I am strong believer in forced appreciation. This can be accomplished in both types of MFR's, the way you justify the new "value" of the property and the way the "value" is capped is just different.

On the topic of scale, I have found very little scale delta between a 4 plex or a 6 plex.  I made the move knowing that I would not see a real advantage, but it was an easy way to test the financial side of my investment strategy and also to further build up my investment resume. I don't plan to get into many, if any more of the small commercial residential buildings.  I personally think the real advantages of scale start to kick in after 10 doors per building.

I guess that was a long winded way of me saying, try it out and if you don't like it you can easily get out... IF you bought correctly in the first place.

Good luck to you and let us know what you decide to do!

-Arlen

3Reply
See this reply in the discussion

11 Replies

Jump to latestLatest
  • Michael Le
    Developer · Houston, TX · Member since 2015 · 1k+ posts · 1k+ votes
    9y

    Hi @Louis A.,

    If you could can easily find properties that provide you 20% COC then I say keep on doing that. Your list of Pros are definitely spot on. However, generally it's not easy to find properties that meet that criteria. The time, energy, and money spent on acquiring one residential property is not too far off on the time required for a commercial. Let's say that commercial properties take 2-3x times as long to find, the number of units you're dealing with is much higher so you're much more efficient and able to scale much quicker.

    Additionally, generally on residential you make your money on the purchase. You buy right and cash flow a couple hundred bucks a month. And if you're lucky and you're in the path of progress, your property appreciates too. With commercial you can buy right but you can also directly add value. You have control over your cash flow and your NOI directly impacts the value of your property.

    You have more economies of scale too. Property management will be around 3-4% instead of 8-10%. You can do stuff like cost segregation that will save you on taxes. You can technically do it with houses too but generally it's not worth it to most people.

    0Reply
  • Louis A.
    OP
    Investor · Chicago, IL · Member since 2015 · 70 posts · 27 votes
    9y

    @Michael Le Thank you -- I may just do that and continue to build scale since all of my units are located withing a 1 mile radius. One thing that still eludes me however is how folks manage the financing. We've been rather fortunate these past 10 years with low interest rates. I'm curious what (investor) contingency plans/strategies are available when lending becomes more expensive?

    I'm certainly no economist, however one may reasonably conclude the following:
    1. Unless you own free an clear, your return on invested capital will reduce significantly
    2. Due to higher interest rates, buyers will have less purchasing power. With a limited pool of buyers, I would expect prices to be somewhat affected.

    Keen to get the BP community insight here.

    0Reply
  • Joel OwensBusiness Member
    Moderator
    Real Estate Broker · Canton, GA · Member since 2010 · 15k+ posts · 11k+ votes
    9y

    Depends on what you are talking about. If you are talking mom and pop commercial sub 1 million in price then you get a lot of crap loans and not many lenders wanting to loan except local banks and a few credit unions. They like to sell 5 year term and 20 year amorts. I never do those loans as I want to be able to give extra to principal when I want but do not want to be required. 

    When you get into larger commercial properties 3,5,10 million properties and higher you not only have small banks but mid and large size banks. In addition you have insurance companies, CMBS, private party lenders,etc.

    We can get 10 year term fixed and 30 year amort. in the 4's for rate. I like my clients to have minimum 7 year fixed rate debt and preferably 10 years fixed. Most cycle are every 7 to 10 years for various asset classes at different points in time. This way my clients can decide when they want to sell or refi versus a 3 or 5 year loan forcing them to sell at a non-optimal time in the market or do a refi with loans they do not want in the marketplace.

    10 years later if they do not want to sell you usually have a good amount of principal pay down and  rental increases so even if interest rates goes up for refi cash flow is still good.   

    Podcast Guest on Show #47
    NNN Invest53 Reviews
    WebsiteView Page
    1Reply
  • Fred Heller
    Real Estate Agent/Property Management · Houston, TX · Member since 2014 · 1k+ posts · 827 votes
    9y

    When you say "commercial" I assume you're referring to retail/office/warehouse as opposed to apartment buildings, which can also be considered commercial from a financing standpoint.

    To me the biggest advantage of commercial is that, depending on the type of lease, you can roll all of your operating costs to the tenants. This includes taxes, insurance, common area maintenance, etc.

    Commercial ownership is a lot more accounting heavy because of what I said above.

    I can't speak to the financing aspect as that is not an area of expertise for me. But I do understand that commercial financing is much more cumbersome than residential.

    0Reply
  • David Thompson
    Investor · Austin, TX · Member since 2013 · 933 posts · 1k+ votes
    9y

    Louis,

    I'll add that the opportunities for scale (touched on earlier) but also forced appreciation w/commercial properties (value add plays) are what attract a lot of folks into this space. The valuation methodology is different, you are not looking at comps as a driver of your value as much but more NOI/cap rate = FMV. A good operator will find property that can be renovated and operated optimally to bring up that NOI and drive up FMV. More difficult to do w/residential.

    0Reply
  • Marc C.
    Buy-and-Hold Rental Investor · Santa Fe, NM · Member since 2015 · 438 posts · 352 votes
    9y

    Office, warehouse, and retail are higher-risk plays than multifamily. If your definition of "commercial" includes those, you probably need to do a lot more education on the subject. 

    As others have said, having a 10-year due date on a loan is a lot better than 5 years. I'm ONLY looking for these at this point, so I have more options if the cycle looks to be turning (and it is right now). 

    For some idea on rates, I like http://www.crefcoa.com/apartment-rates-main.html

    0Reply
  • Louis A.
    OP
    Investor · Chicago, IL · Member since 2015 · 70 posts · 27 votes
    9y
    Originally posted by @Joel Owens:

    Depends on what you are talking about. If you are talking mom and pop commercial sub 1 million in price then you get a lot of crap loans and not many lenders wanting to loan except local banks and a few credit unions. They like to sell 5 year term and 20 year amorts. I never do those loans as I want to be able to give extra to principal when I want but do not want to be required. 

    When you get into larger commercial properties 3,5,10 million properties and higher you not only have small banks but mid and large size banks. In addition you have insurance companies, CMBS, private party lenders,etc.

    We can get 10 year term fixed and 30 year amort. in the 4's for rate. I like my clients to have minimum 7 year fixed rate debt and preferably 10 years fixed. Most cycle are every 7 to 10 years for various asset classes at different points in time. This way my clients can decide when they want to sell or refi versus a 3 or 5 year loan forcing them to sell at a non-optimal time in the market or do a refi with loans they do not want in the marketplace.

    10 years later if they do not want to sell you usually have a good amount of principal pay down and  rental increases so even if interest rates goes up for refi cash flow is still good.   

    Thanks Joel -- Much appreciated and Makes sense. I'll look you up if I ever join the Big-Dog club :-) 
     

    0Reply
  • Amit M.
    Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    9y

    I've also contemplated going into commercial properties. The three biggest determinants IMO are: 1- what are your goals, 2- your specific market location, 3- your financial resources. In my specific case I keep passing on going commercial. And the limited terms of commercial loans (as opposed to 30 yr fixed, which is nationally supported by gov agencies like Freddie Mac) has always been a key factor for me. I'm a BRRRR (hate that acronym btw ;) investor, so ironically I have always ended up refi'ing my 30 year fixed loans every few years. But now that I am (at least semi officially) "done", I think (hope) to keep my existing loans long term. I've pretty much reached my financial goals, and not too keen on managing more properties. Market is at a top too, so good opportunities are few and far. I have also locked in killer low rates the last 2 years. Plus we may be saying goodbye to low rates with the new presidency- fixed rates already went beserk, and the Feds are circling the wagons to get a rate increase on the books before Yellen is replaced.

    So in my case I will need or want to totally redo and trade up my portfolio of 2-4's for commercial. I actually think the long term appreciation is better with my existing properties, which are boutique buildings in very desireable San Francisco neighborhoods. Although most of their forced appreciation has already been executed, their market appreciation rate will remain solid as they are in prime neighborhoods. And I fully anticipate that my income will grow as rents increase in the future. Quite frankly, I don't see the point in risking that, plus needing to leverage, plus the loan differential we discussed, to get into a different asset class. I can sail off into the sunset with my existing portfolio, which includes solid long term rent growth and appreciation. And when I'm sick of managing it I'll just turn it over to a good property manager. I'll shave some $$ off my future income growth for the management.

    To be succinct, my basic investment philosophy is if it ain't broke don't f**k with it ;)

    2Reply
  • Amit M.
    Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    9y

    I'll ping @Account Closed who have experience with both commercial residential and 1-4's, to see if they wish to lend their perspectives. 

    0Reply
  • Arlen Chou
    Investor · Los Altos, CA · Member since 2014 · 942 posts · 1k+ votes
    9y

    @Amit M. thanks for bringing me into this discussion. I am not sure if my perspective will help, but it might be entertaining for a few...

    @Louis A.

    My personal time horizon is measured in decades and generations, so take the following with a grain of salt.

    There are many good reasons to be on either side of this fence. I personally came up through house hacking, then SFR's, then a light industrial building, then some small multi-families, and most recently into "commercial" residential. There are many good reasons to focus on any one of these market segments. Each market niche has its strengths and weaknesses. I believe that matching your personal strengths and weaknesses to the niches is how you will find the right strategy for yourself. Although maximizing things like COC and the best interest rates are extremely important, I think a strategy that fits your lifestyle/personality is more important.

    My personal philosophy is to always be a noobie, so I push my boundaries to test myself and see what I like and dislike and invest in several arenas. I will eventually focus on a single strategy once I either find one I really like or get to tired and need to settle for a market that works on paper.

    I cannot really comment on what might be the best strategy, because as others have said it depends on your goals and timelines. What I can tell you is that I have found through the various market niches is that the common denominator is financing... If you can figure this piece out for yourself, you will be able delve into different market niche and jump back out if you find that a space is not to your liking. At least that is what I am doing. The physical analysis process for the different types of buildings might be slightly different, but the basic principles apply to all properties. On the financial side, I am strong believer in forced appreciation. This can be accomplished in both types of MFR's, the way you justify the new "value" of the property and the way the "value" is capped is just different.

    On the topic of scale, I have found very little scale delta between a 4 plex or a 6 plex.  I made the move knowing that I would not see a real advantage, but it was an easy way to test the financial side of my investment strategy and also to further build up my investment resume. I don't plan to get into many, if any more of the small commercial residential buildings.  I personally think the real advantages of scale start to kick in after 10 doors per building.

    I guess that was a long winded way of me saying, try it out and if you don't like it you can easily get out... IF you bought correctly in the first place.

    Good luck to you and let us know what you decide to do!

    -Arlen

    3Reply
  • Amit M.
    Rental Property Investor · San Francisco, CA · Member since 2013 · 1k+ posts · 1k+ votes
    9y

    @Arlen Chou good perspective and advise there. BTW I wanted to vote on your post but BP isn't showing me the pics and votes on people anymore (just their name, title, city/state on the left side as usual). I'm on an iPad. Is this the new format for everyone?  It's weird not being able to vote on posts anymore!

    0Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free